Having pointed out that Barclays was one of the least culpable banks in the understatement of Libor at the height of the liquidity crisis, I wondered how it came about that all the banks were lying at once.
I think there's a clue in the submissions data. Look at the charts for UBS, Royal Bank of Canada, and WestLB (ignoring one point that looks like an error). The deviations from Libor are tiny. It's impossible for UBS in particular that this bears any relation to its actual borrowing costs: it had reported massive losses on mortgage derivatives in 2007 and 2008 and it would have had to pay higher interest rates than Barclays. I suspect that it had little interest in borrowing in the interbank market, and wasn't getting quotes at all (or if it was, the people getting them weren't the ones responsible for BBA submissions). In that case, the Libor quotes for BBA would have been generated by phoning a few brokers and asking them where they thought the market was, not specifically for UBS. If several banks did the same thing, they would all generate very similar quotes without any sort of collusion.
My speculation is that many of the banks ignored the precise wording of the BBA question "At what rate could you borrow funds...", and answered instead the question "At what rate could a bank with good credit borrow funds..." And that they did it not as a result of any instruction from on high that they should submit low quotes, but because that was a convenient way to get the numbers. Generally it's considered poor manners to ask for a specific quote if you're not interested in trading, but quite normal to ask for information about the market.
So we could be in a bizarre situation where the banks who submitted quotes closest to the truth are deemed to be the worst liars, because they are the ones who made a conscious decision to distort the data.
Showing posts with label Banking. Show all posts
Showing posts with label Banking. Show all posts
Wednesday, 4 July 2012
The curious case of the high low submissions
One of the two charges against Barclays in the Libor fixing scandal is that during the banking crisis it submitted, on the instructions of senior management, artificially low quotes in order not to stand out as a poor credit risk by comparison with the rest of the Libor panel.
Barclays has today issued nine pages of "supplementary information", starting with a further statement of contrition. The document explains that the instruction to lower the quotes was issued by Jerry del Missier, then President of Barclays Capital, following a telephone call on 29th October 2008 between Bob Diamond and Paul Tucker, the Deputy Governor of the Bank of England. Barclays reports that there was some misunderstanding between Diamond and del Missier about exactly what Tucker had said. (This is all consistent with paragraph 176 of the FSA report.) Both Diamond and del Missier resigned from Barclays today.
Barclays' document includes a chart of its rankings relative to the rest of the panel submitting 3-month dollar Libor quotes during November 2008, at the peak of the liquidity crisis following the failure of Lehman Brothers in September that year. It was almost always the highest quote of the 16-bank panel.
The Guardian has helpfully published an interactive chart of dollar Libor up to the end of 2008. It shows that the spread to the fixing of Barclays' quotes for the 3-month rate more than halved on 30th October, and fell to zero at the beginning of December. Barclays' chart is true but not the whole truth. And James Mackintosh of the FT has this chart of sterling Libor showing a quicker and more dramatic change. (The FSA report says, somewhat opaquely, that "After 6 November 2008, changes in market conditions affected Barclays’ LIBOR submissions such that the instruction became redundant.") Nevertheless, it does seem unfair to give Barclays a kicking for this dishonesty when they were lying less than most of the rest of the panel.
The Bank of England knew in October 2008 that Libor fixings were artificially low, not just from market data but because Barclays (and very possibly other banks) were telling them so. But there's no sign that they did anything much about it. We need to know if and when the BoE took action to tell the banks to tell the truth about interbank rates. If the BoE did nothing, it seems quite reasonable for Barclays and others to suppose that the BoE was more concerned about financial stability than about accurate Libor fixings. There are many situations in life when an untruth is expected and as such not immoral. It's not clear to me that this wasn't one of them.
I repeat however that Barclays' manipulation of Libor submissions for trading advantage was truly scandalous. There's no injustice about the consequences of that.
Barclays has today issued nine pages of "supplementary information", starting with a further statement of contrition. The document explains that the instruction to lower the quotes was issued by Jerry del Missier, then President of Barclays Capital, following a telephone call on 29th October 2008 between Bob Diamond and Paul Tucker, the Deputy Governor of the Bank of England. Barclays reports that there was some misunderstanding between Diamond and del Missier about exactly what Tucker had said. (This is all consistent with paragraph 176 of the FSA report.) Both Diamond and del Missier resigned from Barclays today.
Barclays' document includes a chart of its rankings relative to the rest of the panel submitting 3-month dollar Libor quotes during November 2008, at the peak of the liquidity crisis following the failure of Lehman Brothers in September that year. It was almost always the highest quote of the 16-bank panel.
The Guardian has helpfully published an interactive chart of dollar Libor up to the end of 2008. It shows that the spread to the fixing of Barclays' quotes for the 3-month rate more than halved on 30th October, and fell to zero at the beginning of December. Barclays' chart is true but not the whole truth. And James Mackintosh of the FT has this chart of sterling Libor showing a quicker and more dramatic change. (The FSA report says, somewhat opaquely, that "After 6 November 2008, changes in market conditions affected Barclays’ LIBOR submissions such that the instruction became redundant.") Nevertheless, it does seem unfair to give Barclays a kicking for this dishonesty when they were lying less than most of the rest of the panel.
The Bank of England knew in October 2008 that Libor fixings were artificially low, not just from market data but because Barclays (and very possibly other banks) were telling them so. But there's no sign that they did anything much about it. We need to know if and when the BoE took action to tell the banks to tell the truth about interbank rates. If the BoE did nothing, it seems quite reasonable for Barclays and others to suppose that the BoE was more concerned about financial stability than about accurate Libor fixings. There are many situations in life when an untruth is expected and as such not immoral. It's not clear to me that this wasn't one of them.
I repeat however that Barclays' manipulation of Libor submissions for trading advantage was truly scandalous. There's no injustice about the consequences of that.
Saturday, 30 June 2012
Libor Fixing
Barclays has been fined heavily by regulators in the USA and the UK for manipulating Libor fixings, and other banks are under investigation. I've read a fair bit about how shocking the disclosures have been: I'll seek to clarify here what is and what isn't a surprise.
Libor stands for the London Interbank Offered Rate. It is supposed to be "The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size, just prior to 11.00am London time". It's produced by the BBA (British Bankers' Association) for ten major currencies with fifteen maturities in each, from overnight to one year. It's calculated every business day by asking each member of a panel of banks what rate it could borrow at, eliminating the upper and lower quartiles, and averaging the others. There are currently 18 members of the largest panel (for US dollar rates) and six for the two smallest (for Swedish Krona and Danish Krone), so a bad quote from one member of the panel will have a small but not zero effect on the calculated rate unless both the bad and the true quote fall in the same extreme quartile.
Bob Diamond, the Barclays Chief Executive, who seems to have been relaxing with his money while the wrongs were being done, has written to the chairman of the House of Commons Treasury Select Committee to explain in outline what happened. There were two sorts of manipulation: the first went on between 2005 or earlier (the investigation goes back to 2005) and 2008, and involved Barclays' submissions to the BBA being adjusted to suit the position of the trading book - if the book was a net payer of a particular rate, Barclays would submit a low quote, and vice versa. This is truly shocking, the more so in that the traders involved seemed to have been utterly brazen in the emails they sent about it - there seems to have been no sense that they were doing anything improper. Diamond's excuse is that only relatively junior traders were involved in this abuse, but it's elementary that the BBA submission process should have been entirely isolated from trading considerations, and it's a management failing that this was not the case.
The second manipulation occurred during the banking crisis between 2007 and 2009, when Barclays submitted artificially low quotes in order not to stand out as a poor credit risk. Diamond's excuse is that they did it because the other banks were doing it and they would have looked bad by comparison if they hadn't.
Whatever the truth of the excuse, no one who's been paying attention, and certainly not the British Chancellor of the Exchequer, should be surprised to learn that banks were quoting artificially low rates. The Wall Street Journal published reports to that effect in April and May 2008, following a cautious investigation by the Bank for International Settlements (pp59-72 here) which found "Little evidence of manipulation".
The clearest evidence that Libor rates have been unrealistic comes from cross-currency basis swap spreads. These swaps allow one to synthesize a floating-rate loan in one currency from a floating-rate loan in another currency. If banks could borrow freely at Libor in both currencies, the spreads would be close to zero. But here's a chart I created in 2009 for a conference presentation that touched on the subject:
The red line is the cost of borrowing in Euros at the Euribor rate - a rate similar to Libor but calculated by the European Banking Federation. The green line is the cost of borrowing in dollars and using a basis swap to convert the loan into euros. The separation between the two lines, which appears in August 2007 and spikes in November 2008 tells us that one or both of the rates is wrong - in fact it's the dollar rate which is artificially low. If banks could really have borrowed at dollar Libor they would have done that in preference to borrowing at Euribor, but they couldn't. It may be relevant that the Euribor panel is asked a slightly different question - what rate do they think one bank could borrow from another at, rather than what rate could they themselves borrow at. So it is less embarrassing for them to quote a relatively high rate.
Who has been damaged by all this? Diamond claims about the first manipulation that "The interventions in question were typically on the short term one and three month rates relevant to the wholesale markets and not the longer term rates used to set, for example, retail mortgages". I suspect that's inaccurate. Only a small proportion of mortgages use Libor contractually to set their rates, but my brief investigation suggests that in the UK the ones there are mostly use three-month Libor. All the same, my guess is that most mortgage holders will have profited overall from the manipulations, since they kept rates artificially low during the banking crisis. On the other side, any institution which was issuing Libor-based mortgages during 2008 should have been aware of the problems with the numbers and ought to have widened their spreads to compensate. Thus the people with a genuine grievance ought for the most part to be the Barclays' market counterparties who lost out when the fixings were manipulated to suit Barclays' trading book. I don't know how eager they'll be to sue, but I'm sure there will be plenty of lawyers with the whiff of money in their nostrils to encourage anyone with any sort of a claim to have a go.
Update: I recommend this post by Frances Coppola, which includes quotes from the FSA report setting out exactly what Barclays was up to.
Libor stands for the London Interbank Offered Rate. It is supposed to be "The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size, just prior to 11.00am London time". It's produced by the BBA (British Bankers' Association) for ten major currencies with fifteen maturities in each, from overnight to one year. It's calculated every business day by asking each member of a panel of banks what rate it could borrow at, eliminating the upper and lower quartiles, and averaging the others. There are currently 18 members of the largest panel (for US dollar rates) and six for the two smallest (for Swedish Krona and Danish Krone), so a bad quote from one member of the panel will have a small but not zero effect on the calculated rate unless both the bad and the true quote fall in the same extreme quartile.
Bob Diamond, the Barclays Chief Executive, who seems to have been relaxing with his money while the wrongs were being done, has written to the chairman of the House of Commons Treasury Select Committee to explain in outline what happened. There were two sorts of manipulation: the first went on between 2005 or earlier (the investigation goes back to 2005) and 2008, and involved Barclays' submissions to the BBA being adjusted to suit the position of the trading book - if the book was a net payer of a particular rate, Barclays would submit a low quote, and vice versa. This is truly shocking, the more so in that the traders involved seemed to have been utterly brazen in the emails they sent about it - there seems to have been no sense that they were doing anything improper. Diamond's excuse is that only relatively junior traders were involved in this abuse, but it's elementary that the BBA submission process should have been entirely isolated from trading considerations, and it's a management failing that this was not the case.
The second manipulation occurred during the banking crisis between 2007 and 2009, when Barclays submitted artificially low quotes in order not to stand out as a poor credit risk. Diamond's excuse is that they did it because the other banks were doing it and they would have looked bad by comparison if they hadn't.
Whatever the truth of the excuse, no one who's been paying attention, and certainly not the British Chancellor of the Exchequer, should be surprised to learn that banks were quoting artificially low rates. The Wall Street Journal published reports to that effect in April and May 2008, following a cautious investigation by the Bank for International Settlements (pp59-72 here) which found "Little evidence of manipulation".
The clearest evidence that Libor rates have been unrealistic comes from cross-currency basis swap spreads. These swaps allow one to synthesize a floating-rate loan in one currency from a floating-rate loan in another currency. If banks could borrow freely at Libor in both currencies, the spreads would be close to zero. But here's a chart I created in 2009 for a conference presentation that touched on the subject:
The red line is the cost of borrowing in Euros at the Euribor rate - a rate similar to Libor but calculated by the European Banking Federation. The green line is the cost of borrowing in dollars and using a basis swap to convert the loan into euros. The separation between the two lines, which appears in August 2007 and spikes in November 2008 tells us that one or both of the rates is wrong - in fact it's the dollar rate which is artificially low. If banks could really have borrowed at dollar Libor they would have done that in preference to borrowing at Euribor, but they couldn't. It may be relevant that the Euribor panel is asked a slightly different question - what rate do they think one bank could borrow from another at, rather than what rate could they themselves borrow at. So it is less embarrassing for them to quote a relatively high rate.
Who has been damaged by all this? Diamond claims about the first manipulation that "The interventions in question were typically on the short term one and three month rates relevant to the wholesale markets and not the longer term rates used to set, for example, retail mortgages". I suspect that's inaccurate. Only a small proportion of mortgages use Libor contractually to set their rates, but my brief investigation suggests that in the UK the ones there are mostly use three-month Libor. All the same, my guess is that most mortgage holders will have profited overall from the manipulations, since they kept rates artificially low during the banking crisis. On the other side, any institution which was issuing Libor-based mortgages during 2008 should have been aware of the problems with the numbers and ought to have widened their spreads to compensate. Thus the people with a genuine grievance ought for the most part to be the Barclays' market counterparties who lost out when the fixings were manipulated to suit Barclays' trading book. I don't know how eager they'll be to sue, but I'm sure there will be plenty of lawyers with the whiff of money in their nostrils to encourage anyone with any sort of a claim to have a go.
Update: I recommend this post by Frances Coppola, which includes quotes from the FSA report setting out exactly what Barclays was up to.
Saturday, 3 December 2011
FTT and stock market crashes
Could a Financial Transactions Tax in Europe avert major falls in equity markets? I'm going to consider this in the light of major equity index falls working backwards from now.
1) The Eurozone debt crisis sell-off starting in July 2011.
Between 7th July and 24th November this year the FTSE fell by 14.6% in reaction to the Eurozone debt crisis. Its hard to see how an FTT on shares could have had much of an effect on that. It's possible that an FTT on bonds (which is also part of the proposal) could have slightly reduced the falls in sovereign bond prices, but the underlying problem is the massive deficit and debt problems of several Euro countries. (I've put an end date to the sell off at the recent market low, but I'm not promising the decline in equity prices is over.)
2) The Flash Crash of 6th May 2010.
Starting at about 2:40pm on the east coast, the S&P and other major indexes fell about 5% over 5 minutes, then recovered their losses over the next 10 minutes. The exact causes are not definitely known, but it's certain that high-frequency trading played an important part. It's probable that the crash wouldn't have happened had there been an FTT in the US.
However, the temporary crash had no effect on European markets, which were closed. Had the crash occurred earlier in the day, there would have been some reaction in Europe, which would have been smaller with an FTT than without. There's no way to quantify this.
3) The Financial Crisis sell-off between October 2007 and March 2009.
Between the end of October 2007 and 3rd March 2009 the FTSE lost 47.7% of its peak value. This was one effect of a global financial crisis caused by the collapse of a credit boom built on the back of rising US house prices. Banks had built up extraordinary levels of exposure to mortgage-backed securities, but an FTT would have affected this not at all.
4) 9/11
The FTSE fell 5.72% on 11th September 2001, in reaction to terrorist attacks in New York. This was the only one of the ten biggest one-day percentage falls not to have happened in either October 1987 or during 2008. The fall was a rational response to the information then available about the attacks (which occurred during the European afternoon). An FTT would have been irrelevant.
5) The collapse of the tech bubble at the beginning of the third millennium
After reaching a new high on the last trading day of the century, the FTSE fell progressively, reaching a low on 12th March 2003, by which time it had lost 52.6% of its peak value. A lot happens in three years, but the simple explanation is that there was a gradual re-evaluation of the true value of the internet market. An FTT would have no bearing on this.
6) The Russian Financial crisis and the collapse of LTCM, July-October 1998
Between 20th July and 8th October 1998 the FTSE fell by 24% as a result of a financial crisis in Russia and in a reaction to the (not unrelated) failure of the hedge fund Long-Term Capital Management on 23rd September. The market recovered the LTCM part of its losses over the following eight days as it became apparent that the damage had been contained.
It would probably have been impossible for LTCM to have executed its strategies in the presence of an FTT in the USA, so its boom and bust never would have happened. An FTT in Europe would have made little difference to it. So an FTT in the USA could have averted the last 6.6% of the fall.
7) Black Monday, October 1987
The FTSE fell 5.4% on Friday 16th October, and 5.7% on Monday 19th. The major action happened in the US market, which fell precipitously after the FTSE had closed: the S&P lost 20.4% on the day. As a result, the FTSE opened on the 20th down another 18.1%.
The causes of this one were complex. The losses on the 19th seem to have been accelerated by program trading and portfolio insurance strategies in the US. It's possible that an FTT would have discouraged the development of these strategies.
***
Of the seven market falls I've looked at, one, which had no effect in Europe, would probably have been prevented by an FTT in the USA, one would probably have been reduced by it by about a quarter, and one might have been reduced by an unknown amount. None would have been significantly affected by an FTT in Europe.
It's not surprising that an FTT would have more effect in the USA. For regulatory reasons, most share trading in the USA is done on (electronic) exchanges, which makes automated trading much more profitable. In Europe, similar exchanges exist but most large share trades are OTC (over-the-counter).
***
While writing this, I came across this BBC analysis which covers many of the same events (without reference to a Financial Transactions Tax).
1) The Eurozone debt crisis sell-off starting in July 2011.
Between 7th July and 24th November this year the FTSE fell by 14.6% in reaction to the Eurozone debt crisis. Its hard to see how an FTT on shares could have had much of an effect on that. It's possible that an FTT on bonds (which is also part of the proposal) could have slightly reduced the falls in sovereign bond prices, but the underlying problem is the massive deficit and debt problems of several Euro countries. (I've put an end date to the sell off at the recent market low, but I'm not promising the decline in equity prices is over.)
2) The Flash Crash of 6th May 2010.
Starting at about 2:40pm on the east coast, the S&P and other major indexes fell about 5% over 5 minutes, then recovered their losses over the next 10 minutes. The exact causes are not definitely known, but it's certain that high-frequency trading played an important part. It's probable that the crash wouldn't have happened had there been an FTT in the US.
However, the temporary crash had no effect on European markets, which were closed. Had the crash occurred earlier in the day, there would have been some reaction in Europe, which would have been smaller with an FTT than without. There's no way to quantify this.
3) The Financial Crisis sell-off between October 2007 and March 2009.
Between the end of October 2007 and 3rd March 2009 the FTSE lost 47.7% of its peak value. This was one effect of a global financial crisis caused by the collapse of a credit boom built on the back of rising US house prices. Banks had built up extraordinary levels of exposure to mortgage-backed securities, but an FTT would have affected this not at all.
4) 9/11
The FTSE fell 5.72% on 11th September 2001, in reaction to terrorist attacks in New York. This was the only one of the ten biggest one-day percentage falls not to have happened in either October 1987 or during 2008. The fall was a rational response to the information then available about the attacks (which occurred during the European afternoon). An FTT would have been irrelevant.
5) The collapse of the tech bubble at the beginning of the third millennium
After reaching a new high on the last trading day of the century, the FTSE fell progressively, reaching a low on 12th March 2003, by which time it had lost 52.6% of its peak value. A lot happens in three years, but the simple explanation is that there was a gradual re-evaluation of the true value of the internet market. An FTT would have no bearing on this.
6) The Russian Financial crisis and the collapse of LTCM, July-October 1998
Between 20th July and 8th October 1998 the FTSE fell by 24% as a result of a financial crisis in Russia and in a reaction to the (not unrelated) failure of the hedge fund Long-Term Capital Management on 23rd September. The market recovered the LTCM part of its losses over the following eight days as it became apparent that the damage had been contained.
It would probably have been impossible for LTCM to have executed its strategies in the presence of an FTT in the USA, so its boom and bust never would have happened. An FTT in Europe would have made little difference to it. So an FTT in the USA could have averted the last 6.6% of the fall.
7) Black Monday, October 1987
The FTSE fell 5.4% on Friday 16th October, and 5.7% on Monday 19th. The major action happened in the US market, which fell precipitously after the FTSE had closed: the S&P lost 20.4% on the day. As a result, the FTSE opened on the 20th down another 18.1%.
The causes of this one were complex. The losses on the 19th seem to have been accelerated by program trading and portfolio insurance strategies in the US. It's possible that an FTT would have discouraged the development of these strategies.
***
Of the seven market falls I've looked at, one, which had no effect in Europe, would probably have been prevented by an FTT in the USA, one would probably have been reduced by it by about a quarter, and one might have been reduced by an unknown amount. None would have been significantly affected by an FTT in Europe.
It's not surprising that an FTT would have more effect in the USA. For regulatory reasons, most share trading in the USA is done on (electronic) exchanges, which makes automated trading much more profitable. In Europe, similar exchanges exist but most large share trades are OTC (over-the-counter).
***
While writing this, I came across this BBC analysis which covers many of the same events (without reference to a Financial Transactions Tax).
Thursday, 1 December 2011
The FTT, noise trading, and volatility
I summarized quite a lot of research in my post about the FTT and volatility with an airy "There are other high-frequency noise effects which have been theoretically analysed". I'll say a bit more.
First, except in the special circumstances I discussed previously, speculative trading can increase volatility only if it loses money. As Milton Friedman noted in his seminal 1953 paper The Case For Flexible Exchange Rates
But there is only so much money that unsuccessful speculators are willing to lose, so the capacity for speculators to increase volatility is limited. (Bankers have lost apocalyptic amounts of money in the last few years, but not on speculative trading of the sort that might be discouraged by an FTT.)
Nevertheless, the review paper I discussed previously cited no fewer than twelve papers attempting to predict the effect on volatility of a transaction tax. (The ante-penultimate link doesn't now work, and the paper, which is good, doesn't discuss volatility directly.) Each of them sets up an a model of a securities market, and predicts how it will operate with and without a transaction tax by means of theoretical analysis, or by computer simulation of trading strategies, or by having humans playing a trading game.
An essential component for a transaction tax to be able to reduce volatility in these models is the existence of what Fischer Black (of Black-Scholes) called "noise traders". These are traders who speculate in the market without having any information not already priced in, as distinct from "information traders". In Black's conception, traders often do not know which sort of trader they are, which creates uncertainty essential for the operation of a liquid market. The papers I list do not all follow the definition exactly, but they incorporate the concept in some form. Their results seem to depend on to the extent that the way the market is modelled tends to cause the transactions tax to discourage noise traders more than others.
None of the papers has a set-up which is much like actual equity markets: this is partly because they are analysing something like the Tobin tax proposed for FX markets and partly because it's often easier to analyse something other than reality. But it's the equity market that the proposed European FTT is mainly concerned with (the FX market is excluded). And none of the papers includes the full range of trading strategies that operate in actual markets.
A noise trader whose decisions are indistinguishable from random will add a small amount of volatility, and tend gradually to lose money. I am sceptical that there are many traders of this sort. Most speculative traders follow some sort of strategy, broadly the strategies are either trend-following or contrarian. (One of the papers listed explicitly includes both these strategies; others may do so implicitly by using human traders in their simulations.) It's important to include the trend-followers to give a transactions tax a fair chance to reduce volatility significantly
If I were to attempt something like this I would want to include at least the following:
- large trades being executed gradually. This would feed a series of trades in the same direction, with the broker varying the size and timing in an attempt to disguise what he's doing. These trades are profitable for trend-followers
- trades being done for exogenous reasons. These are not strictly noise trades, and will not be deterred by a small transactions tax, but their size and direction looks random.
- information trades (some authors call them fundamental trades). These are done by traders who have used private aptitude to deduce fundamental valuations from public information.
- hedge trades. These are trades done by option traders who are in aggregate either long or short gamma. If option traders are short gamma their hedging tends to increase volatility, and vice versa.
- insider trades. These are trades done using information that is not yet public, but is made public after some time delay. These trades are profitable for trend-followers.
- trend-following speculative trades.
- contrarian speculative trades.
- speculative trades attempting to profit at the expense of other speculative strategies
- a stochastic process for the fundamental value. All traders will be aware of the direction of large changes in fundamental value (corresponding to obviously important news).
That's a lot of things to put in, and a lot of parameters and relative weightings to vary. However, there are only three sorts of trades which tend to increase volatility - short gamma hedging, unsuccessful trend trades (successful trend trades don't increase volatility, they just bring the price change forward), and trades parasitic on trend trades. If things are set up so that trend trading is profitable despite being unsuccessful quite often then a transactions tax sufficient to make it unprofitable can decrease volatility significantly. Note that trend traders do need to trade quite often, because they need to unwind their position quickly if a trend they've traded on fails to continue.
My guess is that with some care it would be possible to create a set-up where this happens. More tentatively, I guess that the actual market doesn't match it.
First, except in the special circumstances I discussed previously, speculative trading can increase volatility only if it loses money. As Milton Friedman noted in his seminal 1953 paper The Case For Flexible Exchange Rates
People who argue that speculation is generally destabilizing seldom realize that this is largely equivalent to saying that speculators lose money, since speculation can be destabilizing in general only if speculators on the average sell when the currency is low in price and buy when it is high.That does not mean that individual speculators cannot profit from activities that increase volatility, but they can do so only at the expense of other speculators. Consider a market in which trend-following speculators are active. An ingenious speculator might create an artificial trend by buying a stock in sufficient volume, causing the trend-followers to start buying into the trend, driving the stock higher. When the clever guy judges the trend-followers have filled their boots, he'll dump the stock at the higher price, locking in a profit. The stock will thereafter gradually revert to whatever it's really worth, and at some point the trend-followers will sell out, realising their losses.
But there is only so much money that unsuccessful speculators are willing to lose, so the capacity for speculators to increase volatility is limited. (Bankers have lost apocalyptic amounts of money in the last few years, but not on speculative trading of the sort that might be discouraged by an FTT.)
Nevertheless, the review paper I discussed previously cited no fewer than twelve papers attempting to predict the effect on volatility of a transaction tax. (The ante-penultimate link doesn't now work, and the paper, which is good, doesn't discuss volatility directly.) Each of them sets up an a model of a securities market, and predicts how it will operate with and without a transaction tax by means of theoretical analysis, or by computer simulation of trading strategies, or by having humans playing a trading game.
An essential component for a transaction tax to be able to reduce volatility in these models is the existence of what Fischer Black (of Black-Scholes) called "noise traders". These are traders who speculate in the market without having any information not already priced in, as distinct from "information traders". In Black's conception, traders often do not know which sort of trader they are, which creates uncertainty essential for the operation of a liquid market. The papers I list do not all follow the definition exactly, but they incorporate the concept in some form. Their results seem to depend on to the extent that the way the market is modelled tends to cause the transactions tax to discourage noise traders more than others.
None of the papers has a set-up which is much like actual equity markets: this is partly because they are analysing something like the Tobin tax proposed for FX markets and partly because it's often easier to analyse something other than reality. But it's the equity market that the proposed European FTT is mainly concerned with (the FX market is excluded). And none of the papers includes the full range of trading strategies that operate in actual markets.
A noise trader whose decisions are indistinguishable from random will add a small amount of volatility, and tend gradually to lose money. I am sceptical that there are many traders of this sort. Most speculative traders follow some sort of strategy, broadly the strategies are either trend-following or contrarian. (One of the papers listed explicitly includes both these strategies; others may do so implicitly by using human traders in their simulations.) It's important to include the trend-followers to give a transactions tax a fair chance to reduce volatility significantly
If I were to attempt something like this I would want to include at least the following:
- large trades being executed gradually. This would feed a series of trades in the same direction, with the broker varying the size and timing in an attempt to disguise what he's doing. These trades are profitable for trend-followers
- trades being done for exogenous reasons. These are not strictly noise trades, and will not be deterred by a small transactions tax, but their size and direction looks random.
- information trades (some authors call them fundamental trades). These are done by traders who have used private aptitude to deduce fundamental valuations from public information.
- hedge trades. These are trades done by option traders who are in aggregate either long or short gamma. If option traders are short gamma their hedging tends to increase volatility, and vice versa.
- insider trades. These are trades done using information that is not yet public, but is made public after some time delay. These trades are profitable for trend-followers.
- trend-following speculative trades.
- contrarian speculative trades.
- speculative trades attempting to profit at the expense of other speculative strategies
- a stochastic process for the fundamental value. All traders will be aware of the direction of large changes in fundamental value (corresponding to obviously important news).
That's a lot of things to put in, and a lot of parameters and relative weightings to vary. However, there are only three sorts of trades which tend to increase volatility - short gamma hedging, unsuccessful trend trades (successful trend trades don't increase volatility, they just bring the price change forward), and trades parasitic on trend trades. If things are set up so that trend trading is profitable despite being unsuccessful quite often then a transactions tax sufficient to make it unprofitable can decrease volatility significantly. Note that trend traders do need to trade quite often, because they need to unwind their position quickly if a trend they've traded on fails to continue.
My guess is that with some care it would be possible to create a set-up where this happens. More tentatively, I guess that the actual market doesn't match it.
Wednesday, 23 November 2011
The Financial Transactions Tax and volatility
The Institute of Economic Affairs has published a report by Tim Worstall setting out a case against the proposed FTT. The article introducing the report asserts, among other things, that "it won't reduce volatility, a desired aim, it will increase it". Richard Murphy, commenting on the report in the name of Tax Research UK, flatly contradicts this "If there was less liquidity in these markets there would, very obviously, be much less volatility than we are witnessing at present". So who is right?
Neither writer troubles himself to say what he means by volatility. When used by sombre-sounding financial news reporters, it tends to mean security prices going down a lot (prices going up a lot are just as volatile, but they don't evoke the same atmosphere of impending doom). But as a term of art in finance, it means the standard deviation of the logarithm of price returns, scaled by the square root of the time interval over which each return occurs - Black and Scholes' seminal 1973 paper on option pricing uses the concept, describing it as the square root of the "variance rate".
In a simple model, security prices follow a geometric Brownian motion. In this model, the observed volatility is expected to be same whatever time interval of returns is used. This model is far from being an exact description of the real world - much published work on option theory is concerned with its flaws - but it is a useful approximation. Under this model, what would be the effect on volatility of an FTT? Assuming that trades become less frequent, but otherwise occur at the same prices, it would make no difference. (The result is essentially the same if one introduces an additional drift to compensate investors for reduced liquidity.)
One minor flaw with the model is that if trading occurs at high frequency, prices may bounce between the bid and the offer, introducing additional volatility if the return periods used to observe it are very short. An FTT would largely eliminate this effect. But the effect does no one any harm, apart perhaps from causing some inconvenience to anyone engage in high-frequency analysis of market-price data. Could this be what Richard Murphy means when he says less liquidity very obviously gives much less volatility? I don't think so, I think he just means that traded prices don't move when no trades occur. Which is true, but not to anyone's advantage.
There are other high-frequency noise effects which have been theoretically analysed. The conclusion tends to be that some reduction in short-term volatility is possible, at least in theory, if some sorts of high-frequency trading can selectively be discouraged. (More on this below.)
A more important flaw in the model is that in practice there are far more large price moves than it predicts, unless one allows very large process volatilities to prevail temporarily. This effect can be modelled by introducing a jump diffusion term to the price process. Although these large price moves may not be related to an underlying volatility process, they nevertheless contribute substantially to observed volatility whenever they occur. So if the incidence of these large moves could be reduced, there could be a substantial reduction in volatility, of precisely the sort one would wish to see if concerned about market price instability.
Some large moves may be caused by speculative activity. Holders of securities may be induced, or even compelled, to sell them if the price falls far enough. For example, as I noted in another post, when sovereign debt yields get large enough margin requirements are made more onerous, making it still more unattractive to hold the bonds and leading to further selling. This can give two distinct possible prices for the same instrument. Speculators may be able to gain by pushing the price from one possible value to the other one. An FTT would inhibit such speculation. So there is at least a mechanism by which it could reduce volatility. Whether this is significant could be determined only empirically.
Which brings us to Worstall's commentary. Whereas his introductory article is emphatic that an FTT would increase volatility, his actual report is more measured: it quotes this from a report by the Institute of Development Studies at the University of Sussex:
Importantly for my argument about jumps, the report notes that:
Neither writer troubles himself to say what he means by volatility. When used by sombre-sounding financial news reporters, it tends to mean security prices going down a lot (prices going up a lot are just as volatile, but they don't evoke the same atmosphere of impending doom). But as a term of art in finance, it means the standard deviation of the logarithm of price returns, scaled by the square root of the time interval over which each return occurs - Black and Scholes' seminal 1973 paper on option pricing uses the concept, describing it as the square root of the "variance rate".
In a simple model, security prices follow a geometric Brownian motion. In this model, the observed volatility is expected to be same whatever time interval of returns is used. This model is far from being an exact description of the real world - much published work on option theory is concerned with its flaws - but it is a useful approximation. Under this model, what would be the effect on volatility of an FTT? Assuming that trades become less frequent, but otherwise occur at the same prices, it would make no difference. (The result is essentially the same if one introduces an additional drift to compensate investors for reduced liquidity.)
One minor flaw with the model is that if trading occurs at high frequency, prices may bounce between the bid and the offer, introducing additional volatility if the return periods used to observe it are very short. An FTT would largely eliminate this effect. But the effect does no one any harm, apart perhaps from causing some inconvenience to anyone engage in high-frequency analysis of market-price data. Could this be what Richard Murphy means when he says less liquidity very obviously gives much less volatility? I don't think so, I think he just means that traded prices don't move when no trades occur. Which is true, but not to anyone's advantage.
There are other high-frequency noise effects which have been theoretically analysed. The conclusion tends to be that some reduction in short-term volatility is possible, at least in theory, if some sorts of high-frequency trading can selectively be discouraged. (More on this below.)
A more important flaw in the model is that in practice there are far more large price moves than it predicts, unless one allows very large process volatilities to prevail temporarily. This effect can be modelled by introducing a jump diffusion term to the price process. Although these large price moves may not be related to an underlying volatility process, they nevertheless contribute substantially to observed volatility whenever they occur. So if the incidence of these large moves could be reduced, there could be a substantial reduction in volatility, of precisely the sort one would wish to see if concerned about market price instability.
Some large moves may be caused by speculative activity. Holders of securities may be induced, or even compelled, to sell them if the price falls far enough. For example, as I noted in another post, when sovereign debt yields get large enough margin requirements are made more onerous, making it still more unattractive to hold the bonds and leading to further selling. This can give two distinct possible prices for the same instrument. Speculators may be able to gain by pushing the price from one possible value to the other one. An FTT would inhibit such speculation. So there is at least a mechanism by which it could reduce volatility. Whether this is significant could be determined only empirically.
Which brings us to Worstall's commentary. Whereas his introductory article is emphatic that an FTT would increase volatility, his actual report is more measured: it quotes this from a report by the Institute of Development Studies at the University of Sussex:
The balance of evidence suggests that there is a positive relationship between transaction costs and volatility, although the size of this effect varies across different studies. Whether a Tobin Tax would affect volatility in the same way as underlying market transaction costs is not clear.and concludes that "this suggests that a transaction tax would increase, not decrease volatility." But the quotation seems to have been carefully selected to suit Worstall's position. The discussion on volatility is much longer and more nuanced. Ideally you should read the whole thing, but I'll offer a flavour of it by quoting the whole of the paragraph Worstall quotes from:
Nonetheless, the overall conclusion from the empirical evidence is more one sided than the theoretical work. The balance of evidence suggests that there is a positive relationship between transaction costs and volatility, although the size of this effect varies across different studies. Whether a Tobin Tax would affect volatility in the same way as underlying market transaction costs is not clear. The Swedish experience of imposing a tax on equity transactions may have increased volatility, but the size of the tax was large; there is no evidence that UK Stamp Duty had any effect on volatility, although it clearly affected returns on equity.My summary is that the theoretical work tends to support the case that an FTT can reduce short-term volatility. The empirical work suggests the opposite, but does not of course rule out the possibility that a carefully designed FTT could work as suggested by the theory. But none of this matters very much because short-term volatility doesn't matter very much.
Importantly for my argument about jumps, the report notes that:
Unfortunately, to our knowledge, there are no papers which look at the impact of FTTs on the probability of a crash or adjustment taking place...We see this as a major gap in the literature.To answer my original question, both Murphy and Worstall are wrong. Murphy is completely wrong, except perhaps under some definition of volatility known only to himself. Worstall is wrong in stating a definite answer to the question not supported by the evidence he cites. The true answer is that we should not expect any great effect on short-term volatility, but that any small effect is somewhat more likely to be up than down. And that there is no way of knowing whether they would be a useful reduction in the risk of the occasional large moves that we really care about when we worry about volatility.
Wednesday, 9 November 2011
EU FTT
George Osborne has responded robustly to a proposal at the meeting of EU Finance Ministers to introduce a Financial Transactions Tax, as advocated by the European Commission, to raise money directly for the EU. For once, I agree with him. It's extraordinary chutzpah to use a Eurozone crisis meeting to propose raising funding with a tax on business conducted largely in one country, the UK, which isn't even in the Euro zone. I suggest instead an ecotax on luxury cars of the sort made by BMW, Porsche, and Daimler.
The European Commission's argument, as stated by José Manuel Barroso, is the EU countries have spent a lot of money bailing out the banks, and it's only fair that the banks should pay it back by means of a tax on their activities. But much of the banking activity in London is conducted by banks based outside the EU - in the USA, Switzerland, and Japan. And the sort of trading that would be prevented by the proposed tax - high-frequency arbitrage - is conducted mainly by hedge funds, which were not bailed out at all.
Is the FTT a good idea? Usually anything that reduces market liquidity disadvantages market participants generally, including the pension funds that many EU citizens depend on. A study by the European Commission estimated that the tax would raise revenue of between 0.13% and 0.35% of EU GDP, while reducing that GDP typically by 1.76%, or perhaps by 0.5% with some restrictions on the application of the tax and using favourable assumptions about the effect of the restrictions. So the expectation is that the tax would depress GDP and hence reduce total tax take. The one advantage from the point of view of the EU is that the reduced tax income would affect national governments, especially in the UK, while the smaller increase would go directly to the EU.
I agree with George.
Update: Here's Kenneth Rogoff against an EU FTT. "...Another possibility is the Europeans concluded that an FTT’s political advantages outweigh its economic flaws...."
The European Commission's argument, as stated by José Manuel Barroso, is the EU countries have spent a lot of money bailing out the banks, and it's only fair that the banks should pay it back by means of a tax on their activities. But much of the banking activity in London is conducted by banks based outside the EU - in the USA, Switzerland, and Japan. And the sort of trading that would be prevented by the proposed tax - high-frequency arbitrage - is conducted mainly by hedge funds, which were not bailed out at all.
Is the FTT a good idea? Usually anything that reduces market liquidity disadvantages market participants generally, including the pension funds that many EU citizens depend on. A study by the European Commission estimated that the tax would raise revenue of between 0.13% and 0.35% of EU GDP, while reducing that GDP typically by 1.76%, or perhaps by 0.5% with some restrictions on the application of the tax and using favourable assumptions about the effect of the restrictions. So the expectation is that the tax would depress GDP and hence reduce total tax take. The one advantage from the point of view of the EU is that the reduced tax income would affect national governments, especially in the UK, while the smaller increase would go directly to the EU.
I agree with George.
Update: Here's Kenneth Rogoff against an EU FTT. "...Another possibility is the Europeans concluded that an FTT’s political advantages outweigh its economic flaws...."
Subscribe to:
Posts (Atom)